Saturday, February 14, 2009

Planning To Buy A House

Are you getting ready to buy a new home? According to CBSnews.com, "Nearly 12 percent of all Americans with a mortgage - a record 5.4 million homeowners - were at least one month late or in foreclosure at the end of last year." This post will help to keep you from joining that group.

In a previous post, I discussed the disadvantages of buying a house. In this post, I focus on ways to reduce the impact of four of those disadvantages -- the ones that are primarily related to income and expenses:
• The risk of foreclosure
• Increased monthly expenses
• Potentially significant start-up costs
• Less predictable expenses

Prepare for the Unexpected with Insurance

Ideally, you want to be confident that you can continue to make your mortgage payments for the life of the mortgage -- no matter what. What happens if you are "sick or hurt and can't work?" This is a double-edged sword of the worst kind. Just when you are hit with unanticipated medical expenses, you are potentially facing an unexpected decrease in your income. This could be devastating. Luckily, there is a way to help protect yourself against both edges of this sword -- insurance.

Many employers provide coverage for routine medical, dental and pharmacy expenses, and "major medical" for the really big bills that would result, for example, from a hospital stay. If your coverage is not adequate, consider buying supplemental insurance. Similarly, many employers provide income continuation (disability) insurance for both temporary and permanent disabilities; this insurance provides income in the event you are disabled -- though typically you'll get 100% of your income for only a limited time. Again, if your coverage is not adequate, consider buying additional coverage. Finally, if you have a family, you'll want to make sure the bills can still be paid even if the unthinkable happens. So, because the bills may continue even if you don't, you'll need life insurance.

Prepare for the Unexpected with an Emergency Fund

An emergency fund is money set aside for, umm, emergencies. Though you have done your best to budget for anticipated expenses (see below), and insured yourself against the standard risks, stuff happens. What if you have a major uninsured or partially insured loss, or lose your job? Unfortunately, your mortgage payment will still be due. (Note: make sure you understand your insurance coverage. "Insured" rarely means 100% insured. For example, if your major medical coverage covers 80% of your hospital expenses, your share of a $25,000 hospital bill will be $5,000. )

An emergency fund of 6 months expenses, plus or minus, provides protection when there are unanticipated decreases in income or increases in expenses; it increases the chances that you will be able to continue to pay your bills, including your mortgage, even in those extraordinary circumstances. The number of months expenses funded generally ranges from 3 – 12 and depends on factors such as perceived risk of income interruptions, adequacy of insurance coverage, ease of finding new employment, etc. This money is typically kept in no or low-risk investments such as savings accounts, CDs, or money market funds.

An Effective Budgeting Process

A very important key to reducing the risks of homeownership is getting your finances under control. In my view, the foundation for this control is a reliable, proven process of annual budgeting and monthly expense control. This is where you plan your savings, the amount by which your income exceeds your expenses. Ideally, you have been able to budget your expenses accurately and to live within that budget for at least the last two years, and as a result have saved enough to make a substantial down payment and cover your start-up costs. If not, now is the time to start.

A sound budgeting process reduces the risks listed at the top of this post in several ways.

It puts you a better position to estimate how much your monthly expenses will increase in your new home. While some of your expenses in your new home will be new and unknown, others may remain unchanged. You will be able to predict the continuing expenses with conviction. For those that change, you will be able to make a reasonable estimate because you at least know what they used to be. Finally, your successful experience with the budgeting process will put you in a much better position to make reasonable estimates for those expenses that will be brand new.

Similarly, budgeting experience will put you in a better position to estimate more accurately the costs you are likely to incur at start-up.

While some housing expenses are “unpredictable,” they are not completely unpredictable. You know you will have unexpected expenses, you just don’t know when, why, or how much they will cost. The fact that you have a budget will at least alert you to the fact that you need to understand what the possibilities are, and encourage you to include an estimate for these items. For example, I generally include at least ½% to 1% of the value of the house per year for home maintenance. I know others who have experienced ongoing maintenance costs of up to 4%/year. If expenses are under budget one year, SAVE that money for the years when you will be over budget.

In addition, I strongly recommend that you prepare a 5-year, or more, plan -- though it does not have to be nearly as detailed as your annual budget. You may even want to consider developing a personal strategic plan. This will allow you anticipate the impact of future events on your ability to pay your mortgage. Do you plan to get married? Buy a new car? Have children? Go back to school? Events such as these could significantly affect your budget. Note that if you have an adjustable rate mortgage, a multi-year plan is MANDATORY. You need to be sure that even if the payments adjust at the maximum rate until they reach the cap you can still make the payments!

Reliable Income

The less reliable your income, the more you are at risk. A steady, reliable source of income for the life of the mortgage helps to counteract the unpredictability of some of the housing expenses. If your income is unreliable, it increases the chances that at some point your expenses will exceed your income, and your risk of foreclosure will increase. Income continuation and life insurance, discussed above, are two products that significantly increase the reliability of your income.

Beyond that, your risk is lowest if you have been consistently employed for at least the last two years – preferably with the same company. The reliability of your earned income may be the factor over which you have the least control. However, even there, in the long run, you exert at least some control by your choice of career, company, industry, location, etc. To the extent that you can, it will be to your financial advantage to choose positions, companies and industries that have the best prospects of long-term employment. To the extent that the reliability of your income is beyond your control, it is important that you recognize the risk, and take appropriate countermeasures elsewhere in your plans – e.g., by increasing the size of your emergency fund.

Conclusion

For many of you, much of this probably seems incredibly pessimistic. However, 30 years is a long time. I think the chances are good that you will experience at least one of these misfortunes some time during the life of your mortgage; you need to be prepared.

Many people feel that a poor credit rating or FICO score is what is keeping them from owning a home; often, not having their finances under control is the real problem. Once your finances are under control, your credit rating and FICO score will naturally improve. From an income and expense perspective, having your finances under control allows you to a) accumulate a substantial amount for the down payment and start-up costs, and b) be as confident as possible that under virtually all reasonably predictable circumstances you will be able to pay your home mortgage – on time -- for the next 30 years. What’s the point of buying a house if you end up losing it in foreclosure?

Preparing for the unexpected, and having a proven budgeting process and reliable source of income are the most important factors from an income and expense perspective in minimizing your risk of foreclosure, and maximizing your chances of becoming a successful homeowner.